The Tax Cuts and Jobs Act
Today, the Republicans in the U.S. House of Representatives released their long-anticipated tax reform bill, entitled the “Tax Cuts and Jobs Act”. While there have been multiple statements from the Republican majority in the House that swift action is expected on this bill, nevertheless the text proposed today all but certainly will be extensively revised in the legislative process. Further, the Republicans in the U.S. Senate are expected to introduce their own tax reform bill as early as next week, and that bill is anticipated to diverge from the House bill in many respects and, in order for tax reform to be enacted, the House and Senate will have to pass a single piece of agreed legislation, which the President must in turn sign into law.
Notwithstanding the very substantial effort that remains before the Congress to enact tax reform into law, the introduction of legislative text along with the publication of a highly detailed summary of each provision is an important milestone in the process and the draft of the bill contains important details.
It is the stated goal of the Republicans in Congress, and the President, to enact tax reform before the end of the calendar year. However, it is not clear that, if that date of enactment were to slip into early 2018, any of the effective date provisions of the bill would be modified, and therefore time to plan around the effective date provisions may be very limited. As a result, taxpayers should consider, now, whether to begin taking steps to plan for legislation that will in large part become effective on January 1, 2018.
Certain significant aspects of the bill are summarized below. However, this summary does not describe all of the proposals in the bill.
20% Permanent Corporate Tax Rate.
The bill proposes a permanent reduction of the corporate tax rate from 35% to 20% beginning in 2018. Prior reports had suggested that the rate reduction would be phased in over a number of years.
Limitation on Business Interest Deductions.
The bill would limit business interest deductions to 30% of adjusted taxable income, as specifically adjusted to approximate earnings before interest, tax, depreciation and amortization (“EBITDA”) for the tax year. “Investment interest” would be excluded, and businesses with adjusted gross receipts of $25 million or less would be exempt. Section 163(j) would be repealed. The provision would be effective beginning in 2018.
Five-Year Expensing for Capital Investment and Expansion of Section 179 Expensing.
The bill permits immediate expensing for certain tangible personal property placed into service after September 27, 2017 and before January 1, 2023. The limitation on section 179 expensing would be increased from $500,000 to $5 million, and the phase out increased from $2 million to $20 million, adjusted for inflation. The expansion of section 179 expensing would be effective for tax years beginning after 2017 and before 2023.
Limitation on Use of Net Operating Losses.
Deductions for net operating losses (“NOLs”) would be limited to 90% of taxable income for a taxable year. NOLs would be carried forward indefinitely to future taxable years, rather than expiring after 20 years, as under current law. NOL carrybacks would generally be disallowed, with exceptions for certain disaster losses.
Denial of Like-Kind Exchanges for Personal Property.
The bill would end like-kind exchanges for personal property (but retain it for real property).
Current Tax on Deemed Repatriated Foreign Earnings.
The bill imposes a one-time tax on the untaxed earnings of foreign subsidiaries of U.S. multinationals. The tax rate would be 12% on cash and 5% on illiquid investments. At the election of the U.S. shareholder, the tax liability would be payable over a period of up to 8 years.
Territorial International Tax System With Special 10% Tax on High-Profit Foreign Subsidiaries.
The bill would shift the current U.S. “worldwide” international tax system under which U.S. companies are taxable on worldwide income to a “territorial” system under which foreign active profits are generally exempt from tax. The mechanism would be to exempt the foreign-source portion of dividends paid by a foreign corporation to a U.S. corporate shareholder that owns 10% or more of the foreign corporation. No foreign tax credit or deduction would be permitted for any exempt dividend, and no deductions for expenses allocable to the exempt dividend would be taken into account for purposes of determining the U.S. corporate shareholder’s foreign-source income. The provision would be effective for distributions made after 2017.
The bill would impose a 10% tax (i.e., half of the 20% corporate tax) on 50% of a U.S. parent’s “foreign high returns” from its foreign subsidiaries.
Foreign high returns would be the excess of (x) a U.S. parent’s foreign subsidiaries’ aggregate net income over (y) the federal short term rate plus 7% times the foreign subsidiaries’ aggregate adjusted bases in depreciable, tangible property, adjusted downward for interest expense, and excluding income that is effectively connected with a U.S. trade or business.
Denial of Excess Interest Deductions.
The bill would limit the net interest expense of a U.S. corporation that is a member of an “international financial reporting group” to the extent the U.S. corporation’s share of the group’s global net interest expense exceeds 110% of the U.S. corporation’s share of the group’s global earnings before interest, tax, depreciation, and amortization (EBITDA). Denied interest expenses could be carried forward for five years.
Excise Tax on Payments by a Domestic Corporation to Certain Related Foreign Corporations.
Under the bill, payments (other than interest) made by a U.S. corporation to a related foreign corporation that are deductible, includible in costs of goods sold, or includible on the basis of a depreciable or amortizable asset would be subject to a 20% excise tax unless the related foreign corporation elects to treat the payment as “effectively connected income” subject to U.S. corporate tax. The provision is silent as to whether tax treaties would apply to exempt the payment from tax.
Treatment of Offshore Insurance Companies as PFICs.
The bill would treat a foreign insurance company as a PFIC unless the foreign company would be taxed as an insurance company were it a U.S. corporation and if its loss and loss adjustment expenses, unearned premiums, and certain reserves constitute more than 25% of the foreign corporation’s total assets (or 10% if the corporation is predominately engaged in an insurance business and the reason for falling below the 25% threshold is solely due to temporary circumstances).
Denial of Treaty Benefits for Payments Made By a U.S. Corporation to a Related Entity.
Under the bill, if a U.S. taxpayer that is controlled by a foreign parent makes interest, royalties, rent, or other fixed or determinable, annual or periodical (“FDAP”) income to another entity in a treaty jurisdiction that is controlled by the same foreign parent, then the 30% U.S. withholding tax would not be reduced by treaty unless the withholding tax would be reduced if it were made directly to the foreign parent.
25% Pass-through Rate.
The bill provides a special 25% pass-through rate for “business income”, with certain rules that are designed to prevent taxpayers who perform principally services to take advantage of it. Net income from a passive business activity would be fully eligible for the 25% rate. Owners receiving income from an active business income would determine their business income by reference to their “capital percentage” of net income.
Presumption That Income 70% Attributable to Labor.
The bill generally allows owners to elect to apply a capital percentage of 30% to net business income from an active business income to determine the business income eligible for the 25% rate. Thus, the bill presumes that 70% of pass-through income is attributable to labor. The 30% election would effectively create a blended rate of 35.22% ([70% x 39.6%] + 30% x 25%]). However, the owners could apply a formula based on facts and circumstances to determine a capital percentage of greater than 30%. The formula would measure the capital percentage based on the federal short term rate plus 7% multiplied by the capital investment of the business. An election to use this formula would be binding for five years.
Presumed Denial for Lawyers and Certain Other Service Providers.
The bill establishes a zero percent default capital percentage for lawyers, accountants, consultants, engineers, financial service professionals, and entertainers. Therefore, these taxpayers would not generally be eligible for the 25% rate. However, the bill does permit these taxpayers to use the alternative capital percentage based on the business’s capital investments.
If enacted as proposed, the bill would encourage business to operate as flow-throughs so that their owners could benefit from the 25% (or even the 35.22% blended rate). It would also encourage employees to seek to become owners of their flow-through employers to obtain the benefits of their reduced rate. The special flow-through rate would also encourage public companies to operate through an “up-C” structure whereby the operating company is a partnership for tax purposes. Finally, the bill would encourage service providers to own their building and equipment so as to qualify for a capital percentage.
Denial of Deduction for Entertainment Expenses.
Under the bill, entertainment expenses would no longer be deductible, although business meals would remain deductible.
Top Rate Unchanged at 39.6%; Four Brackets (12%, 25%, 35%, and 39.6%).
The bill retains the top rate of 39.6%. The other rates are 12% (up from 10%), 25% and 35%. Taxpayers in the 10% bracket would increase to the 12% bracket. The increased standard deduction (discussed below) would avoid the increase for many taxpayers currently in the 10% bracket. However, some taxpayers in the 10% bracket with large families may see an increase.
Married taxpayers filing jointly in the 33% bracket would be increased to the 35% bracket. Taxpayers in the 28% bracket would be reduced to the 25% bracket and taxpayers in the 15% bracket would be reduced to the 12% bracket.
The 12% rate would be phased out for individuals earning more than $400,000 and married couples earning more than $450,000.
The method for adjusting the brackets for inflation would be adjusted based on “chained CPI,” which would cause the brackets to increase at a slower rate than currently.
Increased Standard Deduction; Repeal of Personal Exemptions.
The bill would increase the standard deduction from $6,350 to $12,000 for individuals and from $12,700 to $24,000 for married couples. This increase in the standard deduction would simplify tax filings for millions of low-and middle-income families. However, because the charitable deduction is available only for taxpayers who itemize, the increased standard would tend to reduce charitable contributions. The bill would also repeal the personal exemption ($4,050 for each personal exemption in 2017).
Expanded Child Tax Credit.
The bill increases the child credit from $1,000 to $1,600, and increases the phase out from $75,000 to $115,000 for individuals and from $115,000 to $230,000 for married couples. The bill also creates a new $300 credit for household members who are not children, such as elderly parents and college students. However, the $300 credit expires after 2022.
Increased Charitable Deductible.
Under current law, cash contributions to a public charity are deductible only to the extent of 50% of the taxpayer’s adjusted gross income. The percentage would be increased to 60%.
Repeal of the “Pease” Limitations on Deductions.
The bill would repeal the Pease limitations on deductions, which effectively amount to a 1.18% tax (3% x 39.6%) for certain high-income taxpayers.
Denial of Deduction for State and Local Income Taxes; Limit on Deduction of State and Local Property Taxes up to $10,000.
The bill repeals the individual deduction for state and local income taxes and limits the deduction for state and local property taxes to $10,000 for taxes that are not incurred in connection with a trade or business. State and local taxes incurred in connection with a trade or business would continue to be deductible. The denial of a federal deduction for state and local income taxes would have the greatest impact on individuals living in high-tax states, like New York, California, and New Jersey.
Limitation on Home Mortgage Interest Deduction.
Under the bill, for mortgages entered into after November 2, 2017, mortgage interest would be deductible only on principal amounts up to $500,000 (down from the current $1 million limit). Interest would be deductible only on the taxpayer’s principal residence. Home equity indebtedness would not be deductible.
Repeal of Individual Alternative Minimum Tax (AMT).
The bill repeals the individual AMT.
Repeal of Extraordinary Medical Expense Deductions, Student Loan Interest Deduction, and the Tax Credit for Adoption, Denial of Deductions for Moving Expenses; Exclusion for Employee Achievement Awards.
The bill would repeal the deduction for medical expenses that exceed 10% of adjusted gross income, the deduction for student loan interest, and the tax credit for adoption. In addition, under the bill, no deduction would be permitted for moving expenses, and employment achievement awards would be taxable.
Phase-Out of the Estate Tax.
The bill would immediately double the estate tax exemption from $5.6 million/person to $11.2 million/person, and would repeal the estate tax and the generation-skipping transfer tax in 2024. The bill would retain the gift tax but would lower it to 35%, and would retain the $10 million lifetime gift tax exclusion and the annual exclusion of $14,000. The “step-up” in basis for heirs, which permits avoidance of all income tax on appreciated property bequeathed at death, would also be retained.
The bill amends section 162(m), which imposes a $1 million compensation deduction limitation, in the following significant ways. First, the bill eliminates the “performance-based” exemption that is relied upon by a majority of publicly-held corporations that pay their executive officers annual compensation exceeding $1 million.
Second, additional executives would be subject to the deduction limitation. The definition of “covered employees” (i.e., executives subject to the deduction limitation) is expanded to include the chief financial officer, and applies to any individual who served at any time during the taxable year as a chief executive officer or chief financial officer (rather than based on service on the last day of the taxable year). Also, an individual who becomes a covered employee for any taxable year beginning after December 31, 2016 would continue to be a covered employee in subsequent years.
Third, the bill would expand the number of corporations to which the deduction limitation applies to include any corporation required to file SEC reports under section 12 or 15(d) of the Securities Exchange Act of 1934, including corporations that file solely due to the issuance of public debt.
20% Excise Tax on Tax-Exempt Organizations.
The bill would impose a 20% excise tax on a tax-exempt organization that pays compensation. The 20% excise tax would be applied to any compensation paid to the organization’s “covered employees” (defined as the five highest paid employees) annually in excess of $1 million. An individual who becomes a covered employee for any taxable year beginning after December 31, 2016 would continue to be a covered employee in subsequent years.
Payments to employees that are contingent on their separation from the organization would be subject to the excise tax if the payments equal or exceed an amount that is three times the employee’s base compensation. If applicable, the 20% excise tax would apply to amounts in excess of one times the employee’s base compensation.
Repeal of Section 409A and Section 457A; Changes to Taxation of Nonqualified Deferred Compensation.
The bill would repeal sections 409A and 457A on a prospective basis. The bill proposes a new section 409B which, for services performed after 2017, would tax all compensation deferred under a nonqualified deferred compensation plan as soon as there is no substantial risk of forfeiture with regard to the compensation.
Compensation would be considered to be subject to a substantial risk of forfeiture only if an individual’s right to the compensation is conditioned upon the future performance of substantial services (covenants not to compete and payment conditions that relate to a purpose other than the future performance of services would not count as substantial risks of forfeiture).
Existing deferrals for services performed before 2018 would become subject to this new rule in 2026.
Tax-Qualified Retirement Plans.
Prior to the bill’s public release, there was speculation as to whether it would eliminate or limit the ability to make pre-tax employee contributions to 401(k) plans. The bill would not impact pre-tax employee contributions to 401(k) plans. However, the bill includes several significant changes for retirement plans:
First the bill would loosen the restrictions on hardship distributions from qualified defined contribution plans by allowing eligible participants to withdraw not only elective deferrals, but also account earnings and employer contributions and by eliminating the rule that prohibits a participant from contributing to the plan for six months after receiving a hardship distribution.
Second, the minimum age for in-service distributions from defined benefit pension plans and state and local government defined contribution plans, would be reduced from age 62 to age 59 ½.
Third, employees who terminate employment with outstanding loans from qualified retirement plans would have more time to roll over their outstanding loan balances to IRAs before the balances are treated as distributions.
Finally, the bill would repeal the rule that allows for the re-characterization of traditional IRA contributions as Roth IRA contributions and vice versa.
Under current law, for employers that sponsor both a defined contribution plan and a defined benefit plan, the nondiscrimination rules allow limited cross-testing between the two plans. The bill would allow expanded cross-testing between an employer’s defined benefit and defined contributions. This should help employers – particularly employers with closed or frozen defined benefit plans – comply with the nondiscrimination rules.
Health and Welfare Plans; Fringe Benefits.
The bill contains only a few provisions impacting employer sponsored health and welfare plans and fringe benefit programs. Perhaps the most consequential change is that the bill would eliminate tax-favored dependent care assistance programs. Additionally, employer provided moving expense reimbursement, tuition reductions by educational institutions, educational assistance, and adoption assistance programs would now be taxable to employees. Finally, contributions to Archer medical savings accounts would no longer be deductible or excludable.
Repeal of Private Activity Bonds. Prohibition on Use of Tax-Exempt Bonds to Construct Professional Sports Stadiums.
The bill would repeal tax-exempt interest for all private activity bonds (i.e., loans to private parties). The bill would also prohibit the use of tax-exempt bonds to construct professional sports stadiums.
State and Local Governmental Pension Plans Subject to Tax on Unrelated Business Taxable Income.
Under the bill, state and local entities, such as pension plans, that are tax-exempt under both section 501 and section 115(1) as government entities, would be subject to tax on unrelated business taxable income.
Repeal of the “Johnson Amendment”; Religious Organizations Permitted to Engage in Political Activities and Speech During Religious Services.
The bill would repeal the “Johnson Amendment,” which prohibits section 501(c)(3) organizations from engaging in political activities. Under the bill, political speech would be permitted for a religious organization during a “homily, sermon, teaching, dialectic, or other presentation made during religious services or gatherings”, so long as the organization’s preparation and presentation of the political content occurred in the ordinary course of the organization’s carrying out of its exempt purpose and the associated costs to the organization of including the political content are de minimis.
Change to the Excise Tax Imposed on Investment Income of Private Foundations; Imposition of Excise Tax on Certain Private Colleges and Universities.
The current 1% or 2% excise tax on private foundation net investment income would be fixed at 1.4%.
Private tax-exempt colleges and universities with at least 500 students and assets with an aggregate fair market value of at least $100,000 per student (excluding those assets used directly for purposes of educating students) would be subject to the same 1.4% excise tax on net investment income as private foundations.
Exemption From the Excise Tax for Private Operating Foundations That Are Art Museums.
The current exemption from the 30% excise tax on undistributed earnings of private foundations for certain private operating foundations would be available to an art museum only if it is open to the public for a minimum of 1,000 hours during the applicable tax year.
Exemption for Independently-Operated Philanthropic Holdings from the Excess Business Holding Tax.
The bill would exempt certain private foundations from the current 10% excise tax on the value of a private foundation’s greater-than-20% interests in other for-profit businesses if (i) the foundation owns all of the for-profit business’s voting stock and did not acquire its ownership interest by purchase, (ii) the for-profit business distributes all of its net operating income for the tax year to the private foundation within 120 days of the close of that tax year, and (iii) the for-profit business’s directors and executives are not substantial contributors to the private foundation or make up a majority of the private foundation’s board of directors. This change would appear to benefit Newman’s Own Foundation, which currently owns more than 20% of Newman’s Own, Inc., the food product company created by Paul Newman.